Empirical Asset Pricing

Classes 17-20: Debt Markets and Banks

Jun Pan

Shanghai Advanced Institute of Finance

Shanghai Jiao Tong University

December 9-10, 2019

SAIF 交大高金 Jun Pan 潘军 December 9-10, 2019 1 / 23

Debt Markets and Banks

Capital Markets: In the US, capital markets, fixed income and equity, are a
critical source of capital for businesses and governments (federal, state and local),
funding 65% of total U.S. economic activity.
Debt Markets: Compared with bank lending, debt capital markets provide a more
efficient form of borrowing for corporations. In the US, the ratio of debt-market
financing to bank lending is 80%/20%, and reversed in other developed markets and
China.
Banks: The fixed-income markets have historically been bilateral and performed by
banks. Post-crisis regulatory constraints on balance sheets have forced banks to pull
back from some fixed-income activities.
Repo Madness: The recent repo market disruption (September 2019) is a case in
point of unintended consequences of well-meaning regulations.

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Global Fixed Income Markets

Source: SIFMA

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The US Bond Markets
US Bond Markets, Amount Outstanding ($T)
45
UST $1.1T
$1.6T
40 MBS $1.9T
Corp $3.8T
Muni
35 $9.5T
Agency
ABS
30 MM
Trillion USD

25 $9.9T

20

15 $15.9T

10

0
1980 1985 1990 1995 2000 2005 2010 2015

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Treasury Yield Curve, Monetary Policy, and Macroeconomic Indicators
Treasury Yield Curve, Monetary Policy, Inflation, and GDP
20
Real GDP
2-year Treasury
15 10-year Treasury
Core Inflation

10
Rates (%)

-5 Yellen
Martin Burns Volcker Greenspan Bernanke
Powell
-10
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

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Fed Balance Sheet and Quantitative Easing

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Treasury Amount Outstanding

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Fed Balance Sheet

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Fed Balance and Bank Reserves
Trillion USD
5
Fed Balance, Assets
4.5 Bank Reserves
"Excess" Reserves
4 Required Reserves
Borrowed Reserves
3.5

2.5

1.5

0.5

0
2006 2008 2010 2012 2014 2016 2018

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Bank Reserves by Types

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Composition of Bank Assets

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Banks’ HQLA Assets

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Composition of Banks’ HQLA Assets

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Monetary Base
4.5
Total Monetary Base
4 Currency in Circulation
Balance Maintained

3.5

3
Trillion USD

2.5

1.5

0.5

0
2006 2008 2010 2012 2014 2016 2018

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Repo Scares

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Money Market Rates: Fund Fund and Repo

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Before and After the Crisis

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Intermediary Capital and Asset Pricing, Theoretical Development

Shleifer and Vishny (1997): The limits of arbitrage.

Gromb and Vayanos (2002): Equilibrium and welfare in markets with financially
constrained arbitrageurs.
Brunnermeier and Pedersen (2007): Market liquidity and funding liquidity.
He and Krishnamurthy (2013): Intermediary asset pricing.
Brunnermeier and Sannikov (2014): A macroeconomic model with a financial sector.

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Intermediary Capital and Asset Pricing, Empirical Findings
Adrian and Shin (2010): Aggregate liquidity can be seen as the rate of change of
the aggregate balance sheet of the financial intermediaries, whose marked-to-market
leverage is found in this paper to be strongly procyclical.
Hu, Pan, and Wang (2013): Use price deviations in the US Treasury market to
measure the amount of arbitrage capital in the financial markets; estimate the
premium for this aggregate liquidity risk using cross-sectional returns on hedge
funds and currency carry trades, both known to be sensitive to the general liquidity
conditions of the market.
Adrian, Etula, and Muir (2014): Use shocks to the leverage of securities
broker-dealers to construct an intermediary stochastic discount factor. The
single-factor model prices size, book-to-market, momentum, and bond portfolios
with an R2 of 77% and an average annual pricing error of 1%.
He, Kelly and Manela (2017): Shocks to the equity capital ratio of financial
intermediaries possess significant explanatory power for cross-sectional variation in
expected returns on many asset classes.
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Adrian and Shin (2010)
In a financial system where balance sheets are continuously marked to market,
changes in asset prices show up immediately on balance sheets, and have an instant
impact on the net worth of all constituents of the financial system.
The net worth of financial intermediaries are especially sensitive to fluctuations in
asset prices given the highly leveraged nature of such intermediaries’ balance sheets.
If financial intermediaries were passive and did not adjust their balance sheets to
changes in net worth, then leverage would fall when total assets rise. Change in
leverage and change in balance sheet size would then be negatively related.
Far from being passive, the evidence points to financial intermediaries adjusting
their balance sheets actively, and doing so in such a way that leverage is high during
booms and low during busts. That is, leverage is procyclical.
There are aggregate consequences of such behavior for the financial system as a
whole that might not be taken into consideration by individual institutions. We
exhibit evidence that procyclical leverage affects aggregate volatility and particularly
the price of risk.
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Adrian, Etula, and Muir (2014)

This paper shifts attention from measuring the SDF of the average household to
measuring a “financial intermediary SDF.”
Financial intermediaries fit the assumptions of modern finance theory nicely: they
trade in many asset classes following often complex investment strategies; they face
low transaction costs, which allows trading at high frequencies; and they use
sophisticated, continuously updated models and extensive data to form
forward-looking expectations of asset returns.
Therefore, if we can measure the marginal value of wealth for these active investors,
we can expect to price a broad class of assets. In other words, the marginal value of
wealth of intermediaries can be expected to provide a more informative SDF.

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Adrian, Etula, and Muir (2014)
As funding constraints tighten, balance sheet capacity falls and intermediaries are
forced to deleverage by selling assets at fire sale prices, as in the recent financial
crisis.
These are times when intermediaries’ marginal value of wealth is high. Assets that
pay off poorly when constraints tighten and leverage falls are therefore risky and
must offer high returns.
Equivalently, the cross-sectional price of leverage risk should be positive. These
theories imply that leverage captures aspects of the intermediary SDF that other
measures (such as aggregate consumption growth or the return on the market
portfolio) do not capture.
We provide empirical support for the view that leverage represents funding
constraints by showing that our leverage factor correlates with funding constraint
proxies such as volatility, the Baa-Aaa spread, asset growth, and a
betting-against-beta factor that goes long leveraged low-beta securities and short
high-beta securities.
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He, Kelly, and Manela (2017)

We define the intermediary capital ratio, denoted ηt , as the aggregate value of

market equity divided by aggregate market equity plus aggregate book debt of
primary dealers active in quarter t.
Our main empirical result is that assets’ exposure to intermediary capital ratio
shocks (innovations in ηt ) possess a strong and consistent ability to explain
cross-sectional differences in average returns for assets in seven different markets,
including equities, US government and corporate bonds, foreign sovereign bonds,
options, credit default swaps (CDS), commodities, and foreign exchange (FX).
Assets that pay more in states of the world with a low intermediary capital ratio
(that is, assets with low betas on ηt shocks) also have lower expected returns in
equilibrium. This implies that low capital-risk-beta assets are viewed as valuable
hedges by marginal investors or, in other words, that primary dealers have high
marginal value of wealth when their capital ratio is low.

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